Tales of a Technician: Cash Flow Trickery Part Deux | Tackle Trading
My last post highlighted the poster child strategy for cash flow kings — covered calls. The topic which I wish to pick up on is how to best think about a covered call run amiss. Consider the situation we left with last time:
“If your stock falls (USO, anyone?) you have to keep selling lower strike calls. With XYZ at $100 maybe I start out selling the 105 call. Unfortunately, if the stock drops I’ll have to sell lower strike prices each month to bring in a similar amount of premium — the 100 call, 95 call, 90 call, and so forth. Suppose after six months the stock has descended to $70 and I’m short the 75 call. Sure, I may have brought in some income along the way (say, $7) but I’m down $30 on the stock. Feel free to get all excited about that $7, but let’s be honest, your account value is still down substantially.”
So what’s the proper way to think about your position here? Because of the short 75 call even if the stock were to magically recover back to $100 tomorrow I wouldn’t participate in the bulk of the upside. Tricky, tricky. “
In sum, we’re down $30 on the stock (an unrealized loss) while having captured $7 along the way in call premiums (a realized gain). The fundamental problem is that we need the stock to recover back towards $100 (our original purchase price), and yet by virtue of our short 75 call we are obligating ourselves to sell the stock relatively quickly if it were to ever recover. Side note — our cost basis is really $93 for the stock on account of the $7 premium received over the past six months.
Consider your choices. First, you could buyback the 75 call if the S70 stock were to rally past the $75 zone. Once the short call has been closed you’re left with a straight stock position allowing unfettered participation in the upside going forward. The drawback? You no longer have any protection and you probably just locked in a hefty sized loss on the 75 call.
Second, you could simply stop selling covered calls altogether. Now that the stock is perched at $70 (a substantial 30% discount from its highs) perhaps you’re willing to simply be long stock at this point. At $70 it certainly has less downside risk than at $100. The drawback? What if the stock languishes at $70 for months on end, or worse, continues plumbing the depths? By halting your covered call campaign you may be leaving some serious dough on the table.
Third, stay the course. Remember, short calls limit your profit potential for a time. You’re not limiting your profit potential on the stock forever. Simply for the next month, or however long you have till expiration. The beauty of selling short-term covered calls (one month being the preferred time slot) is that you can adjust the strikes frequently as the stock undergoes price shifts, subtle or otherwise.
For example, though we’re short a one month 75 call against our $70 stock it merely limits our upside to $5 in the stock for one month. After that if the stock is hanging at $80, we could sell the one month 85 call. If the stock keeps powering higher and is sitting at $90 then, you guessed it, we could sell the 95 call. Even if the stock ran through my call strike month after month I’d still be capturing the lion’s share of the upside.
Consider the comparison of someone long the S&P 500 (yellow line) to one that was selling covered calls against the S&P 500 month-after-month (gray line). Though the covered call trader was left slightly in the dust from the 2013 to 2015 time frame, their gain still lifted from 20% to 40% over the same time frame.
They still participated in the bullish revelry and on top of that are well positioned to close the performance gap once the stock rally peters out giving way to more neutral to bearish price action. In fact that’s exactly what we’ve seen over the past few months.
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Originally published at https://tackletrading.com on February 24, 2016.
